1031 exchange
I have been living abroad with my family for 2.5 years. We kept our home in the US and rented it out. We will be moving back to the US in 1 year. However, come November, our home will no longer qualify under the "2 of 5 years" as our primary residence - it will be considered a rental property. So we are now considering either selling before November to avoid capital gains, or moving back into the home for the time required to meet the "2 of 5" rule, or making a 1031 exchange for a new home after November. It's this last option that I have questions about.
Can we do a 1031 exchange of a rental for a primary residence? Or, do we have to make a rental for a rental exchange? In that case, how long do we rent it out? And can we then move into the home and claim it as our primary residence? Or, can we simply move right into it and not worry about whether the new home is a rental or a primary residence?
Expat
Like-Kind Property
Property that qualifies for exchange under Section 1031 must be "like-kind", which is defined in the Regulations as follows:
1. Property held for productive use in a trade or business, such as income property, or
2. Property held for investment.
Therefore, not only is rental or other income property qualified, so is unimproved property which has been held as an investment. That unimproved property can be exchanged for improved property of any type, or vice versa. Also, one property may be exchanged for several, or vice versa. This means that almost any property that is not a personal residence or second home is eligible for exchange under Section 1031. Even the vacation home that is used for that purpose part of the year, and is rented part of the year, is considered "mixed use" property and may be exchanged under 1031 for other mixed use property.
To me your subject property would fall into "mixed use". I would suggest talk with your account or RE attorney to confirm.
I am not giving legal advise, but this is what I would do to cover my exchange.
I would set up a company such as an LLC, I would then place the LLC under a trust. Sell the subject property to the LLC and rent the subject property from the LLC.
I base this on the following facts:
The Tax Reform Act of 1984 made it very clear that partnership interests cannot be exchanged and qualify for deferred gain treatment under IRC §1031. The regulations also interpret no difference between general partnership interests or limited partnership interests. Although actual partnerships can exchange with other partnerships under §1031, the exchange of an individual interest is prohibited.
However, the Omnibus Budget Reconciliation Act of 1990 did amend IRC §1031 to incorporate the use of IRC §1.761-2(a), Election of Partnerships, to not be treated under Subchapter K of Chapter 1 of the Code, for the purposes of taxation. This means that §1.761-2(a) can potentially provide an avenue to utilize §1031 to those investors currently owning partnership interests.
So, how does an election under §1.761-2(a) provide a benefit to the typical investor? Well, if every individual or entity within a partnership, elects to have his individual interest treated as his or her own real property interest, similar to a tenant in common interest, then that individual interest can qualify to be exchanged under §1031. And since that partnership interest can qualify for deferred gain treatment, the amount realized from the sale of that interest can be used to acquire any qualifying replacement property.
Therefore, an interest from a partnership in which all partners have made individual elections under §1.761-2(a) can be exchanged for any other property. And, there is no requirement that the investor exchange into replacement properties with his or her previous partners, only that the exchange be used for investment purposes only and not for the active conduct of a business.
Also, the converse of the above §1.761-2(a) situation is possible. It is permissible for a partnership to acquire a property and elect to have the partnership interests treated as individual real property interests for taxation purposes, at the time of purchase. Therefore, as seen in some sophisticated transactions, particular partnerships which have already ready elected under §1.761-2(a), may be established for the sole purpose to solicit investments from other partners exchanging out of one partnership (with the benefit of §1.761-2(a)) into the new entity. This process enables the Exchangor to exchange out of one previously non-qualifying exchange investment, into one, which provides little or no management and superior cash flow or other benefits.
This strategy can also be used for business assets. In both cases however, it is important to outline the goals and objectives of all parties involved in the exchange.
It should be noted that in every case involving an election under §1.761-2(a), it is critical to evaluate the status of your election and exchange with the advice of a qualified tax professional. They will relate your situation to specific Internal Revenue Letter Rulings and other interpretations, which could assist in the strategic structuring of your transaction.
Now I would start looking for an exchange of like property with another investor that is looking to avoid capital gains as well.
Hope this helps.
[addsig]
JohnMichael is correct. Only investment property or property used in a trade or business can be exchanged for investment or trade or business property. Your residence is neither. Also, a vacation home that has never been rented out is not investment property. This is where JohnMichael is incorrect (although he was well intentioned). There is no such thing in the Internal Revenue Code nor the Regulations nor any Revenue Rulings, etc. that I am aware of that makes a "mixed use" distinction. Either it will be a primary (or secondary residence) or investment (or trade or business property). Investment property is "property held for the production of income." One of the criteria the IRS looks at is if the property was rented out. If not and you used the property as a second home, it is unlikely you can make a good argument for a filing position that the property was investment property qualifying under Section 1031.
Therefore, you will have to meet the criteria for the 2 out of 5 rule or continue renting it and do a 1031 exchange into other investment property. Notice I said other investment property here. If you exchange into a house and then move in as your primary residence your exchange will nor qualify under Section 1031. In that case, you don't get the IRC 121 $250,000 (or $500,000 gain exclusion) AND pay 20% long term capital gains. Ouch! Exchange into a house and rent it out for a minimum of 1 year (or 3 years to eliminate all risk because of the statute of limitations) before moving into it as your primary residence.
You indicate "ex pat." I am assuming you are using the term generically and did not give up your U.S. citizenship or U.S. residency, otherwise you would not be eligible for the $250,000 (or $500,000) gain exclusion.
If you were living overseas because you are in the military, there were some new regulations that were issued in the last month for military and Section 121's $250,000/$500,000 gain exclusion and the 2 out of 5 year rule. Check with your tax advisor as you might still be able to sell your house and get the benefit of the exclusion.
[Therefore, an interest from a partnership in which all partners have made individual elections under §1.761-2(a)]
The election out of the partnership tax rules looks at all of the facts and circumstances. If the property is 100% owned by an LLC you will not be able to elect out of the partnership rules under section 761 because under state law you will be considered to have common ownership and common management. If the LLC is a route that a person is thinking about with another partner and one of the partners does not want to exchange, but rather wants cash out of the deal, I would recommend that the LLC go through a division whereby each investor ends up with his/her 100% owned LLC and the two LLCs enter into a co-tenancy agreement. (i.e., the real estate deed will show the two LLC as undivided tenants-in-common). There was a revenue procedure issued last year dealing with co-tenancy interests that you need to look at to ensure that co-tenancy agreement complies with Reg. 1.761-2. The 100% LLCs are disregarded for tax purposes.
After this transfer (and preferably some time goes by before the property is sold) the partner seeking a 1031 exchange assigns his/her contract to the exchange accomodator to start their deferred exchange.
Taxjunkie